Do the EU’s financial transition plans go far enough?

EU financial regulators will soon have the authority to supervise financial institutions’ transition plans after EU lawmakers adopted the capital requirement directive (CRD) in December. But what will be required in those transition plans is yet to be determined, with some advocates concerned they may not be comprehensive enough.

There’s a bit of tension on how to interpret the law, as “the CRD leaves it open for ambiguity”, said Julie Evain, a research fellow at the Institute for Climate Economics.

The CRD integrates the Basel 3 framework into EU law but leaves the definition of what should be in those prudential transition plans up to the European Banking Authority (EBA). The EBA, which takes a risk-based view, launched a consultation in preparation for its rules which closes 18 April.

Under the CRD rules, banks’ transition plans need to consider short, medium and long-term time frames of at least 10 years. The rules give the European Central Bank (ECB) and other financial regulators, including EU national central banks, the authority to review transition plans and require financial institutions to reduce ESG risks, including those arising from the transition to a green economy.

The EBA’s consultation interprets the CRD in a very narrow way, Evian said, defining the CRD transition plans and the corporate sustainability reporting directive (CSRD) plans as separate, with supervisors controlling a narrower version of the transition plan.

But she also says banks should only have one transition plan to make sure there is consistency between what is in both the CRD and CSRD, and that financial institutions should have objectives “that are more grounded in the real economy”.

“It’s a bit as if the EBA was saying, ‘Oh okay, the banks are sort of the victims from climate change, and they should cover the risk’, but as if they have no role or no direct influence on climate change,” she said.

Instead, the EBA should acknowledge the banks do, in fact, have a role to play in climate change, “because if the bank’s clients are not engaged in the transition, then [climate] risk keeps getting higher and higher and higher”.

Double or single materially?

Another question is whether the EBA’s definition of the CRD rules includes single or double materiality, as it uses the word prudential to define transition plans. While the CRD rules reference financial stability, it is not clear whether it refers just to financial risks from financial institutions (single materiality), or broader impacts on risk, (double materiality).

Single materiality is how climate risk impacts a company’s financial performance, while double materiality considers the effect the business has on the climate and the potential impact on its finances.

Julia Symon, head of research and advocacy at Finance Watch, said a lot of supervisors are vocal in saying they will stick to their mandate of financial stability. Whether that includes double materiality or not depends on how the question of what is financial and what is material is approached.

She believes double materiality should be included in the EBA’s upcoming guidelines, as a lot of unmitigated impacts translate into financial risks as well.

“Double materiality is absolutely relevant, because at the end impacts will always translate back into risks, either at the systemic level or in the longer term. So if you don’t mitigate the impacts, you’ll have huge risks,” she said.

Agnieszka Smoleńska, a professor at the Institute of Law Studies of the Polish Academy of Sciences and the Florence School of Banking, believes the CRD can be interpreted as including double materiality, as it gives bank supervisors the tools to not only manage climate risk but also how banks engage with clients and support them in the transition.

The ECB has already released several guidelines on disclosures covering transition and physical risks that “already includes more of a double materiality perspective”, she said.

The biggest risk she sees is to make sure there is uniformity in how transition plans are approached across various regulators, “they already have very different approaches to treating transition risk”.

Ultimately though, the new rules are a positive step forward in the move to a greener economy, as they give supervisors like the ECB more tools to monitor and enforce bank transition plans, said Symon.

It’s a “behavioral incentive for institutions to take [climate] risks seriously” and for society to reconsider the role that banks play in the transition.

“We should think of what role banks play in all of this… if we agree about mitigating [climate change] then we need to actually transition and decarbonise the economy. Because as long as it’s not done, what there is on the balance sheet of a bank or whatever is on paper doesn’t matter because the risk will not go away,” she said.